Mark Hulbert

Do mutual funds have too little cash?

ANNANDALE, Va. (CBS.MW) - There has been only one other time over the past three decades in which equity mutual fund managers had less cash in their portfolios than they do right now.

Want to guess when that was?

You guessed it. It was March 2000, when the cash-to-asset ratio among U.S. equity funds dropped to 4 percent.

And we all know what happened next...

To be sure, today's percentage is not quite as low as March 2000's. But we're close, according to the Investment Company Institute.

As of the end of December, which is the latest period for which data are available, the cash-to-asset ratio stood at 4.3 percent. (See chart near the end of this column that plots monthly values of this ratio over the past 20 years.)

A number of the advisers whose services I monitor have recently drawn their subscribers' attention to this ominous parallel between current data and the March 2000 level.

Peter Eliades, who edits Stockmarket Cycles, is one of them. Earlier this week he wrote that, on the basis of these historical precedents, "one would have to bet that the next big move in the market will not be to the upside... There is an amazing unanimity of opinion that this is a great time to have money in the market. That unanimity almost guarantees this will not be a good year for the stock market."

There is one newsletter editor, however, who does not believe that it is particularly bearish that mutual funds are holding so little cash. He is Norman Fosback, editor of Fosback's Fund Forecaster. In contrast to these other editors, Fosback grades the current level of mutual fund cash as neutral.

The basis for Fosback's interpretation is provided in a book he wrote in the mid-1970s, titled "Stock Market Logic." He found that the mutual fund cash-to-assets ratio can be transformed into a much better market timing tool by factoring out the level of prevailing interest rates.

The theory behind this adjustment is that mutual fund managers have a stronger incentive to hold cash when interest rates are high than when they are low. Fluctuations in mutual fund cash levels may therefore be caused by interest rate changes, and thus have nothing to do with whether mutual fund managers are more or less bullish on the stock market.

In light of today's interest rates, which are at multi-decade lows, the low level of mutual fund cash is not particularly surprising.

In March 2000, in contrast, prevailing interest rates were markedly higher. Ninety-day T-Bills at that time were paying around 5.7 percent, for example, in contrast to 0.9 percent today.

Therefore, even if today's raw mutual fund cash-to-assets ratio were lower than March 2000's, it still wouldn't necessarily mean that mutual fund managers were more bullish today than then.

It is worth noting, however, that even after adjusting the raw mutual funds' cash-to-assets ratio by the level of prevailing interest rates, Fosback still found that its market-timing record was not perfect. In particular, Fosback found that its record is better at picking market bottoms than tops.

The reason: Its "record at market tops is not quite as good since funds usually work down to a low cash position far in advance of the market peak -- too far, in fact, to provide accurate timing of the actual market high."

Editor's note: The most recent edition of the Hulbert Financial Digest is available by e-mail or regular mail. Highlights this month include:

Year 2002's laggards top the charts in 2003

HFD's Long Term Performance Ratings for more than 500 newsletter portfolios

Profiles of The Prudent Speculator, BI Research, No Load Fund*X and The Investment Reporter

For more information or to subscribe to the Hulbert Financial Digest, click here.

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